RATE CUTS ARE NOT A PANACEA

2008 will be a watershed year determining the course of the US economy for years to come. This course will be determined by the policies of the Bush administration and the Fed in addressing the crisis of confidence in balance sheets.

It should be obvious by now to policymakers, Treasury and Fed alike, that the level of Fed Funds Rate-- currently at 4.25% after a 1% reduction starting from the September 18, 2007 Federal Open Market Committee (“FOMC”) meeting-- is not the reason for the credit crunch/tightening that has been worsening since August 2007. The Fed's attempts at injecting permanent liquidity through reductions in Fed Funds Rate and the Discount Rate have not managed to boost interbank lending nor credit extension by banks to corporates and consumers. Furthermore, the Fed's attempt at injecting short-term liquidity through its new Term Auction Facility (“TAF”) program since December 2007-- implemented both independently and in concert with the major global banks-- have also not managed to give the impetus to increased interbank lending. Indeed, in spite of all these liquidity injections, banks are tightening credit to borrowers across the board, to each other as well as to consumers and corporates alike.

Therefore, a policy successful in averting the looming recession would note the fact that a 1% reduction in the benchmark Fed Funds rate has not only not led to liquidity/credit expansion but rather, in reverse, it has led to further liquidity/credit tightening by banks and investors alike. What is behind the 2007/2008 credit crunch is a crisis of confidence in balance sheets. Credit spreads, indicators of the market's perception of credit risk, have widened dramatically. The "high rates" are not the result of a high Fed Funds Rate, rather they are the result of high credit spreads in the AA bank market, which have exploded since August 2007. The nature of the current crisis of confidence is such that it is driven by the fear that investors/lenders have that what they are buying is, across the board, "junk". Also, this crisis of confidence that has created the credit crunch is different from prior ones because it permeates all rungs and layers of financial sector participants-- the sell side, the buy side, individual investors, etc.-- and asset classes.

This credit crunch will not be solved by further reductions in rates. If policymakers do not intervene immediately with a plan to address the crisis of confidence in balance sheets and instead rely only on further rate cuts to solve the credit problem, the credit crunch will deepen and the specter of a looming recession will grow in conjunction with the risk of our economy running high inflation, signs of which have emerged in the latest indicators.

The most important areas that any plan by policymakers targeted at easing the crisis of confidence in balance sheets should address are the following: (a) fuller balance sheet disclosure; (b) valuation guidelines for all financial instruments, (from exotic derivatives to vanilla products alike) carried on balance sheets—including a requirement for multiple independent valuation sources; (c) risk management policy guidelines—including integration of credit and market risk, inclusion of liquidity risk measures, and disclosure of risk management policies; (d) regulation of rating agencies-- aiming specifically at continuous disclosures of rating methodology across all asset classes, and rating agency relationships with banks, investment banks and issuers to ensure the independence of ratings; (e) regulation of monolines—integrating banking and insurance regulations to create new regulations at the federal level targeted only at monolines.

Policies to address the above issues will lead to a transparency that we urgently need to lift us out of the current credit crunch caused by a crisis of confidence in balance sheets. Transparency is of paramount importance for a smoothly functioning financial market. And at the moment, we are far from both transparency and smooth functioning of markets.

Eunice Bet-Mansour